### On Malinvestment

7/21/2014 01:48:00 PM
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I stopped following Noah Smith's debate with the so-called "Austrian Economists" (which I will refer to as "Austrianists" to distinguish them from economists actually from Austria) when Bob Murphy said this:
"Austrian economics per se doesn’t make empirical predictions–that’s either its virtue or its vice, depending on your methodological views."
Ok, whatever. But the fact that Austrianism is a load of crap doesn't mean that everything any of them have said is totally useless. A lot of Austrianist writings talk about one concept in particular, called "malinvestment," that causes the business cycle. Although many mainstream models include risky investments (not exactly mainstream, but here's one!), few of them contain anything resembling "malinvestment." Yet, I suspect that most people, even most economists, secretly believe something like malinvestment is closer to the truth. Let's leave the models behind for a moment, and examine something that happened in the real world.

I live in a small-town suburb of a big city. In the mid-2000s we got a coffee shop, and it was always busy. A couple years later we got a second coffee shop, and it did decent business as well. Then we got a third coffee shop, a second location of the first coffee shop, a drive-through coffee shop stand, then a coffee-shop/book-store combo, then the national chains took notice and we got a starbucks, then a coffee-shop/church combo (you really can't make this stuff up). Now, the residents of this town are fairly wealthy, but remember this is a small town populated by people who commute down to the big city everyday, and who therefore consume most of their coffee outside of town. Needless to say, we simply couldn't sustain the coffee-shop boom. And because they competed against eachother, we didn't just watch the newcommers go out of business--they all went out of business, more or less at the same time. Not even the original coffee-shop, the one that had been thriving alone, could survive the debt it accumulated while competing against the entrants. But here's the thing: it's pretty clear that this town can support at least one permanent coffee shop.

This looks a lot more like malinvestment than any mainstream theory of business cycles I've ever seen. New Keynesian theory doesn't apply because there was no demand shock--aggregate demand for coffee remained constant the whole time. Real Business Cycle theory doesn't apply because there wasn't any collapse in our ability to produce coffee, we simply tried to produce more than people wanted. It looks superficially like a news-shock model in which hypothetical coffee-shop investors heard that coffee shops in my small-town suburb were the next facebook, but I think even the peddlers of these models secretly know that's not what's happening--no one was predicting that our-town's coffee consumption was booming, just that they would be able to steal enough of the market to make it as the One True Coffee Shop for this town.

If I had to coerce the reality into a neoclassical model, I'd say our coffee shop cycle was a case of failure to converge to equilibrium. Equilibrium models assume not that unprofitable business will be driven out of the market, but that there are no unprofitable businesses in the market. A problem with the standard equilibrium modelling is that they ignore the possibility that unprofitable entrants in a market can stay in business long enough to drive both themselves and profitable incumbents into bankruptcy. Consider a model (I promise, hardly any calculus!) of a coffee shop in a small town. It's a very small town actually--they only demand 10 cups of coffee every month. But that's ok because the shop earns 1 unit of net revenue after paying labor and materials on each cup, and their fixed costs come to 8 units a month. They're earning 2 units of profit every month and, like a good little corporation, remit this profit immediately to shareholders (so that the corporation has zero cash on hand). Now an upstart little cretin from the big city moves in and sees that this coffee shop model is profitable, and sets up an identical replica of it right across the street. Coffee drinkers are indifferent between these two identical shops, so they go to each half the time. This means that both shops are selling only 5 cups a month, accumulating debt at a rate of 3 units a month to cover fixed costs.

Of course, they cannot go into debt for ever. A bit of math reveals that at 5 percent interest the companies become permanently unprofitable after 10 months of competition: The coffee shop needs to borrow 3 units each period for T periods at 5 percent interest, so the real present value of the debts that the coffee shop will accumulate is a geometric series given by $$Debt=\sum_{t=o}^T\frac{3}{1.05^t}=63\left(1-\frac{1}{1.05^T}\right).$$ After date T, the coffee shop will begin earning 2 units of profit for ever after, which it can use to repay the loans. The total real present value of all future profits--the maximum amount of debt the coffee shop could possibly repay--is $$Profits=\sum_{t=T}^\infty\frac{2}{1.05^t}=\frac{42}{1.05^T}.$$ Thus, the loans cab be repaid only if $$\frac{42}{1.05^T} \geq 63\left(1-\frac{1}{1.05^T}\right).$$ Solving reveals that the maximum financing possible is T=10 months. At the 11th month, the coffee shop will default because the size of it's debts exceeds the total sum it will earn over all future periods. At 11 months, both the incumbent and the entrant are rendered permanently, irretrievably unprofitable.

I only do that bit of math so that we can talk about monetary policy. Austrianists see a malinvestment as a story about optimal monetary policy. That's pretty hard to follow, because the connection is pretty ambiguous. Monetary policy affects the above only to the extent that changing the nominal interest rate target temporarily changes the real interest rate in the inequality above--as the real interest rate falls, the T date increases. This, of course, ignores all the demand-side effects that money supply, prices, and interest rates have on the demand for coffee, and even then it is unclear how a lower real rate would actually affect the coffee shop market--regardless of the T date, it is only profitable for at most one of the two companies to borrow at all.

Strictly speaking, the coffee shop situation above shouldn't happen in neoclassical models--such models assume we've already reached a situation where all unprofitable entrants have been driven out of business, without addressing the question of whether profitable businesses can remain in business long enough to outlast unprofitable new entrants. Yet we see it happening all the time in real life--an explosion of new entrants render formerly profitable markets unprofitable for both the new and incumbent firms, with the resulting bust leaving us with fewer firms than the market can profitably sustain. (side note: the last coffee-shop bust happened years ago; since then my small town has had several other boom-bust cycles, most recently involving dance studios.) My suspicion is that something like this coffee-shop malinvestment cycle is what causes macroeconomic business cycles. It's not that businesses are expecting demand to surge in particular markets and turn out to be wrong, but that misguided investors think they can make it in already saturated markets, driving both themselves and the incumbents out of business.

What are the policy implications of malinvestment? It's hard to say without an empirically grounded mathematical model. But my intuition suggests a few things: 1) counter-cyclical monetary policy, tightening access to finance when entrants are upsetting markets and loosening it when incumbents are collapsing, 2) macroprudential regulations that prevent stupid entrepreneurial decisions like entering an already saturated market with a lackluster business model, 3) bankruptcy protections that allow once-profitable incumbents to discharge debts accumulated while competing with insane market entrants. In otherwords, if you think markets are plagued by malinvestment that chases good investment out of business, the policy implications would seem to be much closer to standard Monetarist and Keynesian views than Austrianist free-market liquidationism.
Ralph Musgrave 7/22/2014 02:20:00 PM
Re the 3 suggestions in the last paragraph above, if an economy is at full employment, and the central bank raises interest rates so as to deal with a house or stock market bubble, that will raise unemployment unnecessarily, which is not too clever. (That’s a mistake Sweden made recently, isn't it?).

Re No.2, the idea that central bank officials or some other lot of bureaucrats are good judges of whether there are too many coffee shops, or too much house building taking place is very unrealistic I think.

I favour the Greenspan option, but with the difference that entities that lend (whether they’re called banks or not) cannot have bubbly assets on one side of their balance sheets and liabilities that are FIX IN VALUE on the other. That’s asking for trouble and it leads to bank failures and crisis like the one we’ve just been thru. Full reserve banking disposes of that problem.